We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Friday, July 17, 2009

So the government has found where the "Too Big to Fail" line is, and its CIT. Long-time readers know I was all for bailing out Bear, Lehman, Fannie Mae/Freddie Mac and AIG. I was also all for having the government buy toxic assets. I thought all these things were sensible responses to a very real danger of a economic collapse.

All that being said, there has to be a line, and the line can't be "any firm where there might be pain." That is what we have with CIT. Will it be painful? Yes. CIT is a long-time lender to lots of medium-sized businesses, some of whom might not be able to get other funding. Yes, some of them will wind up going under. But the simple reality is that CIT has been a pretty loose lender for a long time. In fact, I'd argue that CIT was primarily an asset-based lender, meaning that they viewed the collateral asset (e.g., the receivable) as the primary credit factor. Admittedly, I don't know any of CIT's lenders, but just from following the company over the years, that's always been my impression.

In today's world, asset-based lending is all but extinct. Think about it. Its basically the same attitude as the no-doc home mortgage lender. You figure that the house is worth more than the loan, so it doesn't really matter how credit worthy the borrower is. Worst case scenario is that you liquidate your collateral and come out whole.

It isn't that quality collateral can't be a factor in lending, but I really think CIT's model assumes a world of high liquidity. In other words, a world where various pots of money exist to buy up the collateral if need be. This was the domain of certain hedge funds or other alternative asset vehicles at one time. Not any more.

The other problem CIT has is a lack of credible funding source. I use the word "credible" intentionally, because any non-back lender has to be able to prove access to the capital markets, which CIT cannot do. So anyone relying on CIT to fund their business will logically draw down their credit lines, which is exactly what has gotten us to this point. Its about credibility as much as it is about CIT's actual loan portfolio.

Speaking of the loan portfolio, its pretty weak. The Wall Street Journal ran a piece showing how bad their delinquencies are. I don't know this for sure, because I've never owned CIT debt, but I'd bet their delinquencies have always been weaker than the average, just considering their borrower profile. But that's no excuse. The fact is that CIT lends to a lot of businesses that are vulnerable to a deep downturn.

So put this all together, and you have a basic business model: asset-based lender without access to bank funding, that just flat out doesn't fit in today's world. CIT may as well be making type writer ribbons. I'm sorry, it just has to go.

This is the moment were we take the training wheels off the economy. We had to do it at some point. We had to eventually send a message to the world of finance that not everything was going to be bailed out.

How great would it be for CIT to work something out with bond holders? I mean, an actual "normal" deal to avoid bankruptcy? I mean, it would almost be like capitalism is back!

10 comments:

I'm a little surprised that there is no bailout for CIT. I thought it would have shown a little appreciation for the little guys and sent a "We're not here just to save the fortune 500" message.

Mind you I'm speaking purely politically, I don't know what is best economically. I'm worried losing a bank with name recognition these days might bring back some panic, but you can't save everyone forever.

I was short CIT so my opinion is biased. The government should help CIT to at least save its $2.3 billion investment. However, if CIT has a broken business model that would be throwing good money with bad. I think investing in California would be a better investment.

Do you honestly feel that allowing CIT to go into bankruptcy will "restore capitalism"???

I think most would agree that with all that has occurred already in the finance world, that the "die has been cast". Meaning, there is no turning back, and just allot of pain and recognition of the sheer size and magnitude of what we are facing ahead. Also, I do not see mee this as a gloom and doom analysis. I simply see it as reality finally taking hold...

This is the way BK should work - shareholders use it as a cudgel to get a break from lenders when times are tough. If the lenders were savvy and have good collateral, they'll take the BK option and enjoy the asset sale proceeds. If the lenders were loose with their underwriting, they'll enjoy their haircut and equity.

I will say the closest thing I've seen to this is/was Thornburg Mortgage. They couldn't raise capital (liquidity crisis) despite a better than average performing book of jumbo mortgage assets whose appraised value was getting slashed due to securitization and investor's appetite disappearing (liquidity crisis x 2). CIT's in the same boat, though it seems their portfolio of loan assets may be doing worse in terms of delinquency and charge-offs.

So it may be a bankruptcy after all. If CIT can't get access to capital to make new loans, and existing borrowers are performing poorly, how does any shareholder or lender expect them to make a profit and pay back their corporate debt or generate a meaningful equity valuation?

From what I heard today, the motivation for the 11th hour deal may be this:

The lenders in the group (PIMCO et al) own a disproportionate amount of short dated bonds. If they filed BK now, all the unsecured claims are treated equally regardless of maturity. Now that they will have time to complete an exchange offer, the short bonds will benefit disproportionately. The short end was up 5-15 points today while the long end was basically unch.

Another line of reasoning I heard was that they did this to demonstrate that they can access private money which might get the government involved... perhaps by using FDIC insured debt. I don't buy this logic, but 3 years is about the point where there is a price break.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.